This is the 3rd in our series of posts on CVA.
THE DRIVERS OF CREDIT VALUE ADJUSTMENT
(CVA)
In our previous posts, we looked at CVA as a concept and how it is
calculated by banks. But what is it that has forced the banks to
make these calculations - what are the drivers of CVA?
There are 3 main types of drivers that are forcing banks to
calculate CVA, which can be classified as:
Drivers of CVA
Accounting as a driver
It was the implementation of fair value provisions that became
the first main driver of the CVA concept.
These were driven by international (currently IFRS 9) and US
(currently ASC820) accounting standards designed to set out the
requirements for recognising and measuring financial assets,
financial liabilities and some contracts to buy or sell
non-financial items.
In a nutshell, that meant that firms' accounting departments had
to reflect credit quality in the fair value measurement resulting
in a rational and unbiased estimate of the potential market price
of a good, service, or asset. This would take into account various
objective and subjective factors, such as:
Any gains and losses from changes in fair value are recognised
on the P&L.
Regulation as a driver
The introduction of Basel II brought forth standards and
regulations regarding how much capital financial institutions had
to put aside to reduce the risks associated with its investing and
lending practices. However, these rules and regulations only
covered default risk and not CVA risk.
In response to this, the Basel Committee on Banking Supervision
introduced, within the Basel III framework, a new capital charge
for potential mark-to-market losses associated with any
deterioration in the creditworthiness of a counterparty.
These new guidelines presented both a standardised and advanced
CVA charge, which we will look at in more detail later.
Active counterparty risk management
It could also be argued that the crisis and resultant credit
crunch of 2008 was also a key driver of CVA.
It soon became apparent that CVA losses dominated default losses
during the crisis, prompting front offices to realise that better
quantification, pricing, and management of their counterparty risk
was crucial.
As a response, some banks created specific CVA desks to manage
CVA P&L and to collect charges from the originating desks in
return for insulating them against counterparty default losses. Due
to the possibility of the total CVA book representing a large part
of the bank's P&L, it was important to hedge the overall CVA,
therefore avoiding CVA uncertainty and its resultant negative
impact on the bank's profitability.
Basel III's response
Earlier, we touched on the new guidelines presented under the
Basel III framework that were introduced by the Basel Committee on
Banking Supervision in response to the financial crisis.
Designed to strengthen the capital requirements for counterparty
credit exposures that arise from bank's derivatives, repo and
securities financing activities, it also provided incentives to
move Over The
Counter (OTC) derivative contracts to central
counterparties. This introduced a new capital charge for potential
mark-to-market losses associated with the deterioration in the
creditworthiness of counterparty (CVA risk) applications to OTC
derivatives.
When calculating the CVA capital charge, banks either take the
standardised or advanced approach. However, to adopt the advanced
CVA approach, the bank must have regulatory approval to estimate
the exposure-at-default of OTC derivatives using the Internal Model
Method (IMM) approach. It must also have approval for a market risk
internal model covering the specific interest rate risk of
bonds.
It is worth noting that the measurement and hedging of CVA is
starting to have an effect on the markets. For example, in July
2011, the sovereign-credit default swaps market was extremely
volatile and market participants were concerned that the Basel III
capital charge for CVA could cause more problems in the market.
CVA strategies
So far, we have looked at the concept of CVA and the key drivers
behind it. But how do banks deal with it?
Our next post will take a look at the different CVA strategies
that are available to the banks.